States’ troubles (more)

Alice Rivlin at Brookings has a very nice (draft) policy brief on the states’ financial troubles.
She points out the financial difficulties of states and outlines some of the repercussions, especially for lower-income residents.
In addition to laying out how the states got into the current situation, she also suggests some practical policy to address the issues.
Some suggestions made by Rivlin:
Federal:
* Immediate: Federal government aid to states
* Long term: automatic trigger of federal grants in recessions or state crisis.
State:
* States can adopt rules to save more money when times are good.
* Adjust tax mix to keep/include less volatile taxes (like sales taxes).
* Improve sales tax collection/coordination across state borders.
Overall, these recommendations sound like good ideas to me. There does seem to be one (potentially major) problem.
Rivlin suggests that “[c]ongress could enact a permanent program of counter-cyclical revenue sharing, which would trigger automatic federal grants in a recession based on national or state economic indicators or combination of both.”
However, if the federal government does come to the aid of states, or if they adopt a mechanism for providing aid in the future, then the states will have less of an incentive to follow responsible policies in good years. Why run a surplus to create a “rainy day fund” when you know that the federal government will ride to the rescue? (This is simply a moral hazard problem at the state/federal level).
Perhaps one way to solve this problem is to charge the states a premium or require states to put money away in a reserve fund (perhaps a percentage of outlays) when times are good – in essence “forcing” states to save – as a precondition to qualify for recession-time aid.
Anyway, I recommend the reading to better understand what’s going on with states’ budgets.

The State Fiscal Mismatch: Doing More with Less
Unlike the federal government, states must balance their budgets even in a weak economy. They have already dipped heavily into their reserves. Hence, they are once again being forced to make painful choices to maintain budget balance. Some are raising taxes or delaying planned tax reductions. Most are cutting spending substantially. The spending cuts are falling heavily on low-income people at a time when poverty is rising and many low-wage workers are losing jobs. So, once again, state budgets collectively are acting as automatic destabilizers. In the name of budget balance, states are taking actions that delay economic recovery, off-set the economic stimulus coming from the federal budget and monetary policy, and increase the hardship of those already feeling the economic pain.
The story is not a new one–it happened in 1980-82 and again in 1990-91–but the severity of the current crisis dramatizes the pro-cyclical swings in state budgets and the need to seek greater stability. Moreover, state finances matter more than they used to because states have greater responsibilities. States are being asked to raise educational standards, bear the rapidly rising costs of Medicaid, help low-income people find and keep jobs, and enhance homeland security. Since Americans are asking so much of state governments, they need to look for ways of shoring up state finances and mitigating their instability.